What is a Net Worth Audit?
The Net Worth Audit is a method used by the Canada Revenue Agency (“CRA”) to calculate a taxpayer’s income based on the increases to their wealth in a given audit period. Effectively, the CRA compares a taxpayer’s assets and liabilities in one year against the assets and liabilities of the previous year in order to try to estimate the income for that year. If this number ends up being greater than the income originally reported on the taxpayer’s return, the CRA usually assumes that the explanation for this discrepancy is unreported income and proposes reassessments based on that assumption.
What does a Net Worth Audit Entail?
The basic premise of a net worth audit is that the taxpayer being audited is likely to have unreported income that can’t be identified through traditional means. A CRA Auditor will often use the net worth method when he or she believes that the taxpayer’s books and records are either are inadequate, inaccurate, or unreliable and therefore can’t provide an accurate reflection of the taxpayer’s income. Once this is done, an auditor will usually proceed by acquiring information from third parties such as:
- banks and financial institutions;
- credit card companies;
- insurance brokers;
- stockbrokers and investment firms;
- lawyer’s and accountant’s office;
- provincial land registry offices;
- municipalities – municipal taxes, building, and other permits;
- vehicle, vessel and aircraft registries; and
- other individuals or organizations
Once this is done, the auditor starts taking the information from the available financial records in order to form a cohesive picture of the taxpayer’s income. At the end of this audit, all of this information is compiled into a final audit report, which will typically be organized as follows:
- Schedule 1: Balance sheet – Assets
- Schedule 1a: CCA schedule
- Schedule 2: Balance sheet – Liabilities
- Schedule 3: Calculation of the discrepancy in total income per net worth
- Schedule 4: Summary of personal expenditures
- Schedule 5: Analysis of income tax discrepancy per net worth
How Reliable are Net Worth Audits?
One problem with net worth audits is that they can be notoriously inaccurate. This is why they are considered a tool of last resort. The CRA’s own Income Tax Audit Manual admits that “The assessing net worth technique will not measure income with absolute certainty but will give a conservative estimate of income.” For tax lawyers and accountants who deal with net worth audits on a regular basis, this is quite an understatement. To give a small example, suppose a small business owner decides to borrow $100,000.00 from a line of credit account to his operating account in order to help pay for immediate business expenses. As revenue starts flowing into his general account, the business puts money back into the line of credit to repay the loan. Many times, a careless auditor will take the gross deposits of each account without considering the overall context of these deposits, and asses the taxpayer at double or triple the taxpayer’s actual income.
The Burden of Proof is on the Taxpayer
Unfortunately for the taxpayer that has been assessed by net worth audit, one of the basic tenets of Canadian tax law is that the burden of proof is on the taxpayer to disprove the CRA’s assumptions in any given assessment. As the Supreme Court laid out in the case of Johnston v. Minister of National Revenue, the Court will deem the assumptions of the Minister of National Revenue to be true until those assumptions are demolished by the taxpayer. This rule is based on the premise that in a reporting tax system like Canada’s, it is the taxpayer who is in the best possible position to provide information and documents relating to their affairs.
While this may be true, this also places an enormous burden on the taxpayer who now has to review and analyze every piece of information which contributed to the auditor’s net worth assessment and cross-reference that with their documents. This can be an incredibly long and stressful process. However, a good tax lawyer can help navigate taxpayers through this process and successfully challenge the CRA’s assessment.
DISCLAIMER: Please note this article is not legal advice. Always consult a lawyer for legal advice regarding your particular situation. The article is not necessarily a complete and accurate picture of the law – it is an article of a general nature.
Published on November 30, 2021